Opening Credits Roll for Netflix

As an analyst for our lead newsletter service, Stock Advisor, I've been following Netflix (NAS: NFLX) since 2006. So I was very interested in an article my colleague Alyce Lomax wrote last week, "Roll Credits for Netflix," which predicted difficult times, if not the end, for Netflix. Her argument revolved mostly around increased competition, but also mentioned changes at the U.S. Postal Service and the need to please the content providers.

There's lots of competition, she wrote: Streaming by Amazon.com (NAS: AMZN) to its Prime members; on-demand options from Comcast and Verizon; and a newly announced joint streaming deal between Coinstar's (NAS: CSTR) Redbox division and Verizon. All of these have the potential to interfere with Netflix's streaming model.

She also pointed out that "courting and keeping studios in their good graces (and offering streaming titles)" is difficult, maybe thinking of the loss of Liberty Media's (NAS: LMCA) Starz programming at the end of this month.

"Show me the money!"Last point first. In an interview with Netflix CEO Reed Hastings at D9 last summer, Kara Swisher asked, "You've now handed over buckets of money. Now I go [to Hollywood] and they love Reed Hastings, they think he's the best thing ever ... Is it just handing over money to Hollywood people and that's the end of it?"

Hastings answered, "Yes."

That drew a laugh before he continued, "The whole relationship thing is overstated. If you have a big checkbook, you know, you can do business and make them money. Part of our goal is to make subscribers really happy and part of it is to make content producers really happy. That's in writing big checks; it's also the promise that as we grow, the checks will get bigger." Seems simple: Write big checks, stay in their good graces.

It looks easy, but ...A common bear argument is that it's easy to do what Netflix does. Buy some content, stream it. Amazon is viewed as a threat because it can presumably afford to buy lots of content thanks to its strong balance sheet. However, after following Netflix for nearly six years, I've got to tell you: It's not that easy.

For instance, in 2008, Starz discontinued its Vongo streaming service. Starz has access to tons of content, but it couldn't make a successful go of online streaming.

Hulu started streaming to the public almost four years ago and still has only 1.5 million paying subscribers. It presumably has inexpensive access to tons of its owners' content (i.e. from Walt Disney, NBCUniversal, and News Corp), yet four years after launch, its paying domestic subscriber base is just 7.4% that of Netflix's.

Launching a streaming service is not merely a matter of getting content together and pushing it out to subscribers. Look at cable television with its hundreds of channels. People watch all that? Earning low returns for supplying content is not sustainable, which partly explains a long history of cable providers raising your rates.

In contrast, Netflix has for years been tracking what content is actually watched by its customers. Thus, it has hard data about the value of content, giving it an advantage in negotiating licensing deals in order to get the highest return on its investment. Knowledge, not content, is king.

There can be more than oneMany analysts seem to think that Netflix or Redbox or Hulu or somebody has to be the clear winner in streaming, crushing all contenders. But "streaming" encompasses many different ways of consuming electronic video entertainment. There's pay-per-view -- basically, paying a few dollars to watch something once -- at which Apple's iTunes, Amazon, and Wal-Mart Stores' Vudu excel. There's new content that Redbox and Hulu are strong in. There are online versions of services you already pay for -- HBO Go and ESPN3 come to mind -- either bundled with your subscription or for an extra fee. And there's the inexpensive, all-you-can eat, monthly subscription -- a place that Netflix owns.

Just as there are many different grocery stores, with some who specialize and others don't, there's room for many different providers of streaming content. In that same D9 interview, Hastings pointed out that to consumers, Netflix is complementary to other sources of video entertainment. It's another source, not the only source.

International is just beginningA year after launching in Canada, Netflix reached break even on an operating basis. Last year, it launched into 43 countries in Latin America, and earlier this year it began its service in the U.K. and Ireland. Right now, Netflix is expecting to lose money in 2012. Netflix has paused its expansion, wanting to reach global profitability on a quarterly basis before expanding further. That doesn't mean each region has to be profitable, just that the company as a whole has to be.

I expect expansion will resume in early 2013 and follow a measured pace after that. Spain is a likely next location, and it's expected Netflix will expand to India and Asia along with the rest of Europe. There are a lot of people around the world.

In fact, according to analyst group Broadband Forum, there were over 580 million broadband lines in the world at the end of last year's third quarter. At the end of 2011, Netflix had 23.5 million total streaming subscribers. How big can it grow? In the U.S., streaming has penetrated about 24% of broadband. Worldwide, though?

Assume it can reach 15% penetration over the next several years. At $8 per month, that's $8.3 billion in revenue a year. Assume a 6.6% net margin -- Netflix's five-year average -- and assign a 25-times multiplier, justified given its growth, and we get a $13.8 billion company, not as big as Apple for sure, but about double its current size. Note, that this back-of-the-envelope valuation uses lower average revenue per user and a lower PE ratio than it currently has. Plus, the last time Netflix saw a full-year net margin lower than 6.6% was in 2008.